This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, click the "Reprints" link at the bottom of any article.

September 3, 2014

PIMCO’s Gross Prefers Bonds to the Mattress, St. Louis Fed Not So Sure

Two wonky papers discuss the velocity of money and its implications for investors

PIMCO bond manager Bill Gross says the Federal Reserve’s low policy rate is sufficient to provide a return on investment for stock and bond owners, but does not induce the sort of productive investment needed to generate long-term economic growth.

In his September investment outlook appropriately titled “For Wonks Only,” the fund manager offers his insights into the economic theory behind his oft-stated “New Neutral” thesis, which holds that a levered global economy severely limits how much the Fed can raise rates.

The former must constantly expand at a high enough rate to pay interest on previously issued liabilities so as not to trigger the need for the sale of existing assets.

If the current rate on outstanding debt in the U.S. is 4.5%, the Fed should target credit expansion of at least 4.5% per year. Nevertheless, credit expansion has averaged just 2% for the past 5 years and only 3.5% in the past year.

U.S. underachievement in credit creation is to blame for today’s economic stagnation, where the economy struggles to reach 2% real GDP growth.

A second variable of monetary policy is the velocity of money. Gross says no central banker knows how fast money should be changing hands in the economy and must therefore only dial the level up or down cautiously in order to avert a credit collapse.

But as a general rule, he writes, “the projected return on financial assets (relative to their risk) must be sufficiently higher than the return on today’s or forward curve levels of cash (overnight repo), otherwise holders of assets sell longer-term maturities and hold dollar bills in a mattress — lowering velocity and creating a recession/debt delevering.”

We may be “dangerously close” to that level where the mattress is more appealing than a Treasury bond, Gross warns.

Indeed, the portfolio manager says that were it not for the Fed’s low policy rate, which he has argued will peak at 2% in 2017, stock prices would be too risky relative to their return at today’s interest rates.

For now, Fed policy is supportive of continued asset price growth, but long-term economic growth will not be forthcoming absent productive investment in the economy.

Gross says that central bankers are looking hopefully to elected leaders to solve that problem of weak growth through deficit policies and tax reform that might revive “capitalistic animal spirits.”

Meanwhile, the Federal Reserve Bank of St. Louis released an economic paper early this week that offers a fresh take on one of Gross’ concerns, the velocity of money.

Indeed, the authors say it has grown at a pace of 33% a year between 2008 and 2013, compared with just below 2% a year for the economy.

Since economic theory suggests that the difference between monetary growth (33%) and output (2%) should be reflected in the price level, the question is: why have we not seen 31% inflation in the past five years of monetary stimulus and low growth?

(The authors also posit that higher economic growth was a theoretically possible outcome as well, but either way growth plus inflation should have equaled 33 — the level of monetary growth.)

“The answer lies in the private sector’s dramatic increase in their willingness to hoard money instead of spend it,” write Li and Arias. “Such an unprecedented increase in money demand has slowed down the velocity of money.”

In other words, the Fed’s huge increase in the supply of money has been counterbalanced by consumers’ redirecting those funds into their mattresses — precisely the precipice to which Gross argued our economy is dangerously close.

Li and Arias attribute consumers’ hoarding to a weak economy and a “dramatic decrease in interest rates that has forced investors to readjust their portfolios toward liquid money and away from interest-bearing assets such as government bonds.”

The Fed’s zero-rate policy, they say, has essentially “reinforced the recession,” triggering a decrease in the velocity of money that is 69 times larger than economic theory would suggest.

While Gross’s New Neutral suggests that investment assets remain attractive at today’s low policy rates, Li and Arias observe that the behavior of ordinary Americans at least suggests “the best form of risk-free liquid asset is no longer the short-term government bonds, but money.”